Managing longevity risk in pension funds

14 December 2020

The emergence of increasing longevity as a risk in pension funds is a product of an undeniably positive achievement. As populations have benefited from improved access to healthcare, improved quality of life and preventative treatments, mortality rates have continually dropped. In fact, prior to the onset of the global pandemic, statistics from the Continuous Mortality Investigation revealed that mortality rates in England and Wales had fallen by 3.8 per cent lower in 2019 than in 2018. Longer lifespans are, without question, a triumph for society. So, naturally, longevity risk and the financial threat attached is usually an afterthought for those who do live past the average life expectancy.

From a pension scheme’s perspective, however, longer lives correspond to worse funding positions. In fact, if pensioners live longer than expected – even just one year past life expectancy – as much as 5% will be added to a pension fund’s total liabilities.

As a result, those in charge of pension schemes are experiencing more uncertainty than ever about the longevity of their scheme members and, in turn, the true cost of their pension liabilities. Over the last decade alone, unanticipated increases to life expectancy rates have added around £250bn to UK private sector deficits.

Coupled with volatile equity markets, inflation and a low-interest environment, longevity risk is a considerable cause for concern for pension trustees as it becomes increasingly difficult to earn sufficient returns to compensate. In this blog, we will be talking about the key elements of longevity risk in pension schemes and what you can do to manage it.

What is longevity risk?

Longevity risk can be defined as ‘the risk that members of some reference population might live longer on average than anticipated’. In defined benefit pension schemes, longevity risk is the risk that scheme members will outlive their life expectancy, which results in the need for pensions to be paid out for longer than expected, costing schemes more overall.

It is possible to break down longevity risk into three elements:

1.    Base table risk

Base table risk refers to the risk of misestimations in current rates of mortality due to the limitations of national life expectancy data or recent scheme experience.

2.    Year on year improvement risk

As the name suggests, this refers to the risk that year on year improvement in mortality rates have been mis-estimated.

3.    Individual risk

Should your scheme’s members happen to defy predictions or trends based on data and live much longer than expected, this will come as a “spanner in the works” of pension fund risk modelling and require more funds to be paid to the members.

Then there’s a fourth risk – measurement risk. This doesn’t relate to how long people live, but more, how our estimates for mortality rates evolve over time. Quality of life, access to healthcare and an unpredictable economic climate make it increasingly difficult to predict life expectancy. Naturally, the more information you have on your members and the more you understand the longevity risk in your scheme, the better placed you are to make decisions regarding investment, funding and de-risking.

How can longevity risk be mitigated?

As the costs associated with defined benefit pension schemes increase alongside rising life expectancies, companies are moving away from DB funds and replacing them with defined contribution funds in order to transfer the longevity risk from the corporate sponsor to the individual scheme member. However, such structural changes generally only apply to future benefit accruals for current and future employees.

Historically, hedging longevity was seen as expensive – but in light of the current situation and increased competition in the insurance market, record levels of activity in managing longevity risk have been noted. Today, a growing number of trustees and sponsors have started to explore innovative solutions for managing the mortality risk in the face of mounting uncertainty. However, no solutions are free of costs, so before any decision can be taken, schemes must weigh out the benefits against the price-tag.

Longevity swaps

When it comes to mitigating longevity risk, the most established approach is to transfer it to an insurance company. Longevity swaps are a perfect example of this. By purchasing a longevity swap, the scheme agrees to make a series of fixed payments in exchange for a floating series of payments from an insurance company based on the average life expectancy of scheme members. In this case, no money is exchanged upfront – rather, the insurer agrees to pay the scheme if longevity rates rise, while the scheme agrees to pay the insurer if rates fall. For trustees, longevity swaps allow for retention of the scheme’s assets, enabling it to continue to invest to outperform liabilities.

Buy in

Alternatively, schemes can opt for a buy-in, whereby the insurance contract becomes an asset of the scheme and monthly payments are made by the insurance company to the scheme in relation to benefits of scheme members. A premium is paid by the trustees to the insurer in return, although the trustees and sponsoring employer will retain ultimate responsibility for meeting members’ benefits. The advantage of a buy in is that there will always be sufficient funds available no matter the longevity of the scheme’s members.

Buy out

A buy out transfers the longevity risk from the trustees and sponsoring employer to an insurance company in exchange for a premium, paid by the trustee. Under the terms of a buyout policy, the insurer agrees to pay the benefits as defined in the scheme for covered members. Once a buyout has been undertaken, the scheme will usually wind up after around 6 months to 2 years, and the insurance company will issue individual policies to members. In undertaking a buyout, the employer and the trustees completely remove their liability in relation to the member.

Whichever approach trustees take, longevity risk should remain a consistent feature of the risk landscape that is assessed regularly to determine the best strategy based on accurate member data. For more advice on managing longevity risk, get in touch with our specialist pension lawyers through our online chat service or quick contact form.

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